China rate cut knocks legs from under yuan rally, more volatility seen

By Pete Sweeney

SHANGHAI (Reuters) - China's surprise interest rate cut is another step toward softening the country's exchange rate, setting the yuan on course to end the year lower for the first time since its landmark revaluation in 2005.

The People's Bank of China (PBOC) cut one-year benchmark lending rates on Friday, a move celebrated by Chinese corporates struggling against a toxic combination of high debt load and weak end demand. [ID:nL3N0TB3VW]

Analysts say it could also signal the end of a rally in the yuan (CNY=CFXS) since May, especially if the central bank follows up with a cut to reserve requirement ratios, which would flood money markets with cheap renminbi.

Investors have long been attracted to yuan-denominated assets, seen as relatively safe given implicit government guarantees, and at the same time higher yielding than similarly rated dollar-denominated instruments.

These high yields, along with the prospect of forex appreciation, encouraged speculative "hot money" to flow into China, maintaining upward pressure on the exchange rate. Friday's rate cut now reduces the relative attractiveness of the yuan and makes it more risky to hold going forward.

"The rate cut overnight, along with prolonged weakness in the Japanese yen, will increase political pressure on the PBOC to allow a modest devaluation in the currency, both to reflect a normal market response to rate cuts and also to shore up export competitiveness in the face of downward pressure on Asian currencies across the board," Eurasia Group analysts wrote in a research note distributed to clients on Saturday.

The yuan dropped sharply at the start of the 2014, losing over 3 percent in the course of two months, a phenomenon widely seen as an attack on currency speculators by Beijing. The currency remains down 1.17 percent for the year, despite rising steadily since May.

Markets were already growing wary of that trajectory, however, given a 10-percent rally in the U.S. Dollar Index (.DXY) in the second half of the year, followed by broad drops in Asian currencies led by the Japanese yen (JPY=). [ID:nL3N0T317B]

But economists warn that the PBOC is unlikely seeking to provoke a dramatic drop, and markets did not aggressively revalue the offshore yuan (CNH=D3) in response to the announcement.

"China has a broader agenda, involving economic reform and rebalancing, which sets it apart from the other countries involved in global currency tensions," wrote HSBC economists in a research note, arguing the ultimate outcome would be more forex market volatility, as opposed to steady rises or declines.

"Structural reforms could be accompanied by lower growth, inflation, gradually lower interest rates, and a smaller savings-investments gap (implying a smaller current account surplus). All of these actually indicate less room for further currency gains."

(Editing by Jeremy Laurence)